Bad News Do Not Always Travel Slowly: The Bankruptcy Case

Abstract

This paper tests to what extent the Hong and Stein (1999) model explains the stock price performance of firms filing for Chapter 11 bankruptcy. In line with the model’s main prediction, I find that the market severely misprices (correctly prices) the bankrupt firms for which information is likely to diffuse slowly (rapidly) across investors. My key finding is robust to a range of alternative methods for adjusting for risk and different periods for computing the abnormal stock returns. My innovative framework provides an acid test of the predictive ability of the Hong and Stein (1999) model, with my results suggesting that it offers important insight into the workings of financial markets, even in the very extreme setting I consider.

Keywords: Corporate bankruptcy, gradual diffusion of information, event study, behavioral finance models

JEL Classification: G14, G33